In the two decades before the 2008 financial collapse, the investment banking industry sidled up to state and local finance officials with an offer they couldn’t refuse. Instead of issuing plain vanilla 30-year fixed-rate bonds to build roads, schools and parking garages, why not sell variable rate bonds at lower rates and buy a swap that would fix the total payment at something lower than what they’d pay in the fixed-rate market?
The government agency got a slightly lower rate, while the investment bank earned fees. If the variable bond’s rate rose above the fixed rate target – the scenario that government finance officials feared most – the swap counterparty (the banks often off-loaded the instruments to speculators) paid off the government agency. If the variable bond rate went down, the swap payments moved in the other direction: from taxpayers to speculators. Either way, the government’s total cost was supposed to stay fixed.
The banks behind Libor have been reporting incorrect lower rates to make their finances appear more stable. Government investigators and regulators are also investigating allegations that bank insiders manipulated the Libor rates to benefit their proprietary trading desks.
Estimates have stated that more than $200 billion in government agency swaps contracts were affected by the rate manipulation and total losses to governments alone could be in excess of $1 billion. A report issued in early June by a coalition of urban transit advocacy groups estimated the Libor scandal cost 13 big city transit agencies $92.6 million in reduced payments, led by San Francisco’s Bay Area Rapid Transit system with a $17.1 million loss and the New York Metropolitan Transportation Authority with a $16.9 million loss.